Bank opacity - patterns and implications

Summary

Focus

How much do investors know about the composition of banks' portfolios? What parts of banks' balance sheets are least known to investors? What is the impact of public data releases on bank equity prices and CDS spreads? Do banks whose credit risk is underestimated by markets get cheaper funding and make riskier loans? We examine these questions by combining a novel event study methodology with a rich data set on the exposures of European banks.

Contribution

We calculate a new measure of bank risk using a rich data set on banks' exposures to individual countries and sectors. We employ a novel methodology, which allows us to evaluate the impact of public data releases on bank equity prices and CDS spreads. Our empirical framework allows us to identify two effects of new information: the reduction of overall uncertainty and the update of investors' estimates of bank risk. We also investigate the impact of bank opacity on bank funding, lending and profitability.

Findings

We find that investors were not fully informed about bank lending portfolios. Bank equity prices and CDS spreads reacted strongly to public releases of data on banks' exposures. The impact of new data was highest for European periphery banks' sovereign exposures and European core banks' private sector exposures. Banks with underestimated credit risk had lower funding costs and borrowed more. If they were from the European periphery, such banks also made riskier loans and had higher profits.

Abstract

We investigate the patterns and implications of bank opacity in Europe using a rich bank-level data set. Employing a novel event study methodology, we document that public data releases by the European Banking Authority (EBA) on banks' exposures to individual countries and sectors contained information that was not previously priced by equity and CDS markets. We demonstrate that the degree of bank opacity varied considerably across bank nationalities and counterparty sectors – it was highest for European periphery banks' sovereign exposures and European core banks' private sector exposures. Furthermore, we document that underestimations of banks' credit risk by markets were associated with lower funding costs and higher wholesale borrowing (for all banks) as well as with greater risk taking and higher profitability (for European periphery banks).

JEL classification: F34, G21, G28.

Keywords: bank opacity, asymmetric information, event study, credit risk, asset markets.